Looking through supply-side inflation is a flawed approach: Viral Acharya

Financial market dominance over central banks is a huge problem and challenge, former RBI deputy governor Viral Acharya says

Since disruptions on the supply side translate into an actual rise in inflation prints and consequently influence household price expectations, it is flawed for central banks to look through this phenomenon, says former Reserve Bank of India deputy governor Viral Acharya. In an interview ahead of the three-day meeting of the Monetary Policy Committee (MPC), Acharya tells Bhaskar Dutta that even central banks are not able to separate out when you can say inflation is caused by a supply shock, which means households and workers would be able to do that to an even lesser extent. Edited excerpts:

Q. The world over, perhaps, central banks have misread the pulse of inflation over the past few months. For emerging market (EM) economies like India, how much of a role does monetary policy play when significant drivers of inflation have emanated from supply-side shocks?

A. I think you are spot on that central banks misread how persistent the undercurrents of inflation were. Typically, supply shocks are thought to have relatively short half-lives — they dissipate very quickly and so inflation doesn’t generally get entrenched.

There might have also been a little bit of the desire to focus on growth instead of inflation, given the nature of the pandemic — the health and the humanitarian aspect of it, wanting to ensure that the kind of rock-bottom scenario that people had imagined, would not materialise.

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However, what the central bankers seem to sometimes miss is that the supply side does lead to a push in inflation prints. Inflation prints are the way that a lot of the expectations of the common man are formed about where price levels are going.

It can be food, it can be fuel, it can be the kind of services you consume such as personal care items, restaurant bills, etc. For households and even perhaps corporates and their employees, when the supply side is pushing inflation prints to higher levels, they gradually start revising their inflation expectations upwards.

Even central banks, with their sophisticated bodies of economists, are not able to separate out when you can say that inflation is caused by a supply shock versus a demand shock. So clearly households and employees of corporates would be able to do that to an even lesser extent.

What I’m trying to say is that inflation expectations are rather heavily influenced by past inflation prints. In economics these are called ‘adaptive expectations’, wherein agents form expectations not necessarily with the best forecasts one might in theory have about the future, because that requires a lot of complex model assumptions. And, so, in a robust model averaging sense, the agents say: Let us just go with some averaging of what the past inflation prints have been like.

We see this a lot in household expectations data; that personal experiences shape your inflation expectations. If they shape your inflation expectations, that could lead to higher expectations of wages.

If you take the United States, for example, the inflation is not just in the items being sold. It’s now also in the wage bill of companies. That then creates a ratcheting up of inflation.

So, I’m fundamentally questioning the thesis that the supply side of inflation can be looked through.

If it’s a very short-lived supply shock you look through it because then inflation will quickly rebound back to normal levels. And then adaptive expectations don’t get adjusted to realised prints.

But the longer the supply side persists, adaptive expectations conclude that inflation might be driven by a particularly persistent shock.

To summarise, the central banking mantra that you can look through supply-side shocks can be fundamentally flawed in a world in which households and corporate employees form expectations in an adaptive manner. Because then that affects wages. Once it feeds into wages, corporates have to price their products higher in order to meet their costs. Then you get a push through of that cost into the second round and then you see the ratcheting up of inflation.

Q. There has been growing talk of the ‘impossible trinity’ that many central banks, including the RBI, are facing, given the immense volatility in global flows of capital. What are your views on navigating the trilemma?

A. I would say it’s really this two-fold path of having clarity of objectives that helps navigate through the maze… the first of which is that the interest rate policy has a clear inflation-targeting mandate.

That’s important because that’s how you anchor expectations, that’s how you handle core inflation — which has gotten entrenched into various parts of different economies.

As I mentioned, such anchoring itself has some collateral benefits on the external sector. If you’re on track to maintain inflation at your mandated levels, that itself would ensure that capital outflows are not as bad as in some other countries where the inflation targeting framework is not as strong as in India.

Secondly, you do have to manage exchange rate volatility because EMs often end up in scenarios where if the currency depreciates too quickly and they are seen not to be among the top performing EMs, then they could see a relative portfolio adjustment of investors away from the underperforming EMs towards the better performing ones.

You have to manage that kind of decline or excessive volatility. The RBI, for instance, certainly has the stock of reserves to provide that kind of smoothness with regard to the volatility of the rupee.

The third thing, however, is that the combination of the external sector headwinds and the domestic inflation, especially on the food, fertiliser and fuel fronts, has some other challenges.

You can either allow a pass-through of the inflation impulses to the consumer, which will mean that the central bank needs to more proactively adjust interest rate policy to keep inflation and inflation expectations anchored. Or, you can absorb some of the inflation impulses into the government machinery to absorb food, fuel and fertiliser price shocks, so that the end inflation is less than what it would be with a full pass-through, freeing up the central bank from having to raise interest rates as strongly.

But then, you would be building in slightly more pressure on the fiscal front. In India’s case, because of the impact of Covid-19 and the related growth shocks, fiscal numbers – in a stock sense of the debt-to-GDP ratio – have risen to much higher levels than what they used to be.

In a flow sense, perhaps the tax collections are okay. But, we also have to worry about the stock. So, I would say that in the case of India, normally when people talk about the impossible trinity, etc., they don’t actually think that hard about the fiscal situation of a country. This would be an error of omission. More generally, EM policy, given the last 10-12 years of borrowing spree, needs to factor in fiscal considerations.

Specifically for India, given that the government does use fiscal policy to absorb some of the price impulses, I would recommend some attention be paid to efficiency of expenditures. Conversely, the central bank’s policy would have to calibrate itself in such a way that it helps bring core inflation down and not leave too much of a burden on fiscal policy for the management of inflation.

Q. Are central banks, including the RBI, working at cross-purposes —swiftly raising rates on the one hand but maintaining surpluses of liquidity on the other?

A. Essentially the world over what we are seeing is that unconventional monetary policy – flooding the market with a gush of liquidity – is easier to push, but very hard to exit.

In general, central banks seem rather reluctant to unwind the liquidity surplus conditions they have created because the markets, banks, non-banks, etc., get used to the borrowing cost impact of that surplus of liquidity. All of this means that when central banks unwind, just like regular interest rate hikes, there is another tightening of the financial conditions that the system may be under-prepared for.

Central banks are, therefore, reluctant to normalise in a manner that might lead to a chaotic or turbulent adjustment in the markets. This can be called the ‘financial market dominance’ over the central banks.

I believe this is a huge problem and a significant challenge. In the case of the US, it injected liquidity after the Global Financial Crisis. Then it injected liquidity after the pandemic. In the case of India, liquidity was adjusted to a significant surplus even before the pandemic, and then we injected even more after its outbreak.

You can see that no central bank has any clear exit plan. No one said that they will withdraw liquidity by X or Y date. No one specified the macroeconomic conditions based on which they will calibrate the pace of withdrawal of liquidity.

The idea behind central banks injecting liquidity is to tell the market —as much as you want is available. Because they are trying to take risk off the table, they’re trying to compress borrowing costs and loosen financial market conditions to a point where people are willing to take all the risk that is out there, perhaps even with some disregard for risk altogether.

But then, of course, as the central banks start tightening and unwinding, the risks start getting re-priced. And that is when the financial dominance of central banks plays out.

Central banks find themselves trapped and need to be extremely careful in weaning the system off that liquidity. In my view, the normalisation of liquidity is almost something that has to happen contemporaneously with the tightening of monetary policy in the sense of raising interest rates.

Because otherwise the two arms of central bank policy are not in sync with each other. Some players say if you raise interest rates and there are some financial market accidents, rollover costs increase for corporations because of tighter financial conditions, and borrowing costs of governments increase too.

Now, should the central bank then intervene and soften these borrowing costs? That would be a complete undoing of the interest rate policy. Why are you raising interest rates if not to compress demand and that way to bring inflation down?

If you start loosening financial conditions while raising rates, then the two arms of the central bank are not working in line with each other. This can have adverse bearing on central bank’s inflation credibility with collateral damage on the external sector in case of emerging markets.

Q. You have earlier spoken about froth building in financial markets because of the easy money conditions. How much of a risk does the reversal pose, say in India’s case?

A. There is no risk in my view in a steady state sense. The RBI used to maintain a small deficit and then ensure through daily or weekly injections or withdrawals of liquidity, that the money in the money markets was moving roughly at the policy rate.

The system knows how that works. It’s not like the system has never been in that mode. The key point is that the transition – from the current point where there is a lot of liquidity to the one where you get back towards some notion of neutral liquidity or maybe a small surplus of liquidity – means financial conditions are going to tighten.

And the question is have you prepared the markets adequately for that? Have you prepared banks and financial institutions adequately for that? Do they have provisions to absorb mark-to-market losses on treasury positions?

It becomes a bit like a game of chicken, which is that if the central bank doesn’t show clarity of purpose that it means to withdraw the liquidity, then banks, financial institutions, and large corporations can continue to keep leveraging themselves up and keep borrowing at short maturities.

If they do so, it makes it harder for the central bank to unwind. What the central bank has to do then is to have and demonstrate clarity of purpose that it is definitely trying to bring inflation down.

For that, it needs to tighten monetary policy, which means raising rates and withdrawing liquidity.

Simultaneously, they have to monitor financial stability, they have to require or cajole financial institutions into improving the maturity structure of their liabilities, towards having long-term liabilities.

Once markets know the central bank is on this inflation-targeting path, they see it in evidence, then they internalise it, and the system gradually adjusts. It’s not like the world has never been in a deficit liquidity system before. It may or may not be necessary to go all the way there – small surpluses may not be too different structurally than small deficits, in that they do not create liquidity dependence and financial market dominance of central bank policy.

The key question in the end is: Does the central bank have credibility on its policy objectives? If it does not, then it could lose the game of chicken and get trapped in the easy monetary policy.